Beijing-based journalist Andrew Peaple, who pens the “Heard on the Street” column in the Wall Street Journal, published a perceptive and unsettling article yesterday revealing how large losses from prior bad loans have been concealed on the balance sheets of China’s “Big Four” state banks. Andrew is a friend and we have had many conversations on this topic, trying to puzzle out what’s really going on. The full article can be found here, but requires a subscription to view.

The basic story is as follows. In the 1990s, China’s “Big Four” state-run banks — the Bank of China (BOC), Industrial and Commercial Bank of China (ICBC), Construction Bank of China (CCB), and Agricultural Bank of China (ABC) — had the primary responsibility for funding the country’s state-owned enterprises (SOEs), many of which were not commercially viable. A substantial number of loans — in the 20% range, by official counts — went bad, leaving China’s banking system on the verge of insolvency. The banks had to write off large parts of their loan portfolios and the Chinese government had to step in and recapitalize them to the tune of US$100 billion. Today, according to official statistics, the non-performing loan (NPL) ratio at China’s commercial banks has been brought under control and now stands (as of June 2009) at a comfortable 1.8%.

But the write-offs and recapitalizations are only part of the actual story. The bulk of bad debts were not written off as losses by the banks, but off-loaded onto state-run Asset Management Companies (AMCs). As Peaple notes, “The AMCs bought about $200 billion of bad debts in 1999 — at face value — and issued [10-year] bonds to the banks as payment.” On their balance sheets, the banks simply swapped $200 billion of loans for $200 billion of bonds. The AMCs, whose only assets were the bad debts, would repay these bonds, plus interest, by disposing of these bad debts.

Now if you think about that for just a moment, you’ll realize it makes absolutely no sense. The $200 billion worth of loans the AMCs purchased were damaged goods, and worth nowhere near that amount. In fact, as Peaple points out, when the AMCs did sell parts of their bad debt portfolio, they received around 20 cents on the dollar. Yet from these proceeds, they are expected to repay the banks the full $200 billion plus interest, as though the loans they bought were perfectly healthy.

Now I don’t want to use sensational language too freely, but this “off balance sheet” arrangement displays some elements of a Ponzi scheme. Most Ponzi schemes involve the misappropriation of funds from one party to another, and that’s clearly not the case here. But the basic mechanism of a Ponzi scheme is the hiding of past losses by drawing down principal in order to pay it out as though it were profit. That is precisely what is happening here. The AMCs are using the proceeds from selling the impaired principal (the bad loans, at 20 cents on the dollar) to pay the interest on the bonds. The fact that the AMCs are keeping up interest payments makes the bonds look good, when in reality the principal needed to repay them in full, when they come due, is long gone.

Under normal circumstances, the banks should recognize that the AMCs do not possible have the means to repay the bonds when they reach maturity, and write down the value of the bonds accordingly. In effect, they should admit that the bad debts they sold the AMCs were worth nothing close to the $200 billion they are still keeping on their books. The reason the banks have been able to avoid doing this so far — and presumably the reason their auditors have allowed them to — is that the AMC bonds are ostensibly guaranteed by the Chinese government. If the AMCs default, as they must, the government has promised to pay up.

Andrew and I have always figured that this is, in one form or another, what would happen when the bonds came due. Rather than have the banks very publicly write down large and embarrassing losses, China would quietly recapitalize the AMCs so they could pay off the bonds. In effect, the real bank bailout would end up being much larger than the $100 billion provided directly to the banks, but it would occur in such a backdoor manner that hardly anyone would notice. And with $2 trillion in foreign currency reserves available to inject as new capital, China could easily foot the bill without even blinking (it wouldn’t even have to sell off its reserve holdings of U.S. Treasuries, just transfer a portion to the AMCs, and thence to the banks as repayment).

The reason for Andrew’s article this week is that the first of the bonds, $36.2 billion issued by Cinda Asset Management to CCB in exchange for its bad debts, came due this Monday. Of course, Cinda was in no position to pay. But instead of stepping in to fulfill its guarantee, and pay off the bond, the Chinese government simply extended the bond’s maturity by another 10 years. In effect, it instructed CCB to roll over the loan. Cinda can continue to pay interest out of impaired principal, with everyone pretending that the bonds are, in fact, worth their face value.

How serious are the numbers involved? As Peaple notes, the $36.2 billion owed to CCB by Cinda is worth more than half of the bank’s net assets (assets in excess of liabilities, the margin that keeps a bank solvent). Other Big Four banks are owed similar sums, by other AMCs: ICBC holds $46 billion in bonds, while Bank of China holds $23 billion. Overall, says Peaple, the total sums are roughly equivalent to a quarter of China’s current fiscal stimulus package. Taken together with new bad debts that many economists think will arise from China’s runaway lending boom this year, the exposure is quite alarming.

These are huge holes in China’s bank balance sheets. The only reason the banks are not being forced to recognize huge losses is the government’s guarantee to back the bonds when they (inevitably) default. But the government’s decision to roll over the Cinda bonds this week, and avoid paying up, calls this guarantee into serious question. Instead, as Peaple concludes, “the problem has been deferred for another decade, letting the government off the hook. And China Construction Bank can keep recording a $36.2 billion amount on its balance sheet it may never receive.” What will global investors in CCB, ICBC, and Bank of China, which are all listed on the Hong Kong Stock Exchange, make of that?